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Where to Get Off-the-Chart Yields

Looking for a stunning, double-digit yield? If you can afford a calculated gamble, consider real estate investment trusts that invest in mortgages. These aren't REITs that own and develop apartments, offices, shopping centers and storage space and make money from rents or by selling land and buildings. Mortgage REITs are leveraged investment companies that buy and sell loans and other real-estate-related securities. The REIT structure spares them from income taxes as long as they distribute 90% of net income as dividends, the same as any other REIT. But that's the only similarity. In every other respect, these are far removed from the property-owning trusts.

Mortgage REITs are a risky concept because they borrow to buy mortgages, which magnifies the returns — both up and down. If they buy "nonagency" loans, a term that means loans that are not backed by the likes of the Government National Mortgage Association (Ginnie Mae) or the Federal National Mortgage Association (Fannie Mae), there's also the risk that borrowers' defaults will diminish the value of their portfolios. For that and other reasons, the financial markets price mortgage REIT shares to offer a drastically higher current yield than other kinds of REITs. This is the case in both good economic times and not-so-good times.

And there's your big chance. If you believe that both the housing market and the economy are not just on the mend but about to enjoy good growth, think of this as an opportunity and not a pool of risk. "This is a great environment to be a mortgage investor," says Jason Stewart, an analyst with Compass Point Research. So far in 2013, he's right. Through the first two months, the category shows a total return of 11.7%. Because the average yield is 11.5%, the REIT shares are holding their value even as they pay these enormous dividends.

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Stewart particularly likes REITs that have a greater percentage of nonagency debt, despite the theoretical risk of high defaults. The potential profits with nonagency loans, which REITs buy at discounted prices but which come with higher interest rates, are greater. And those loans are increasingly valuable today because real estate prices are rising, making the loans stronger as collateral.

But are the dividends secure? Stewart says yes, and the industry's dividend record since the 2008 financial meltdown is reassuring. Moreover, if housing and commercial real estate continue to improve, these REITs could gain book value (assets minus liabilities), which in turn should push up their share prices.

That said, interest rates are a potential problem. If they move up more than just gradually, mortgage investors can lose capital as they are stuck with a portfolio that is dominated by relatively poor-paying loans. Higher short-term interest rates would also raise the mortgage REITs' cost of funds and threaten serious dividend cuts. (Hint: Always look to see that any REIT you invest in has a positive "net interest spread" on its statement of operations.)

The sensitivity to interest rates means these are not buy-and-hold stocks, says Merrill Ross, REIT analyst with Wunderlich Securities. "You have to keep an eye on the Fed," she says. "As short-term interest rates start to rise, it's a good time to get out of these stocks."

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Yet, with the Fed vowing to keep rates low, the yields on mortgage REITs are high enough to be compelling. These five have the management chops to negotiate a tricky market and enough of their assets in nonagency debt to gin up generous returns (prices and yields are as of March 7):

We'll start with American Capital Mortgage (MTGE; price, $26.22; yield, 13.7%). It invests in federally guaranteed mortgage loans as well as in commercial loans and has about 10% of its assets in nonagency residential loans. American Capital bought most of its nonagency loans at a steep discount to their face value, which Stewart expects will fuel the trust's earnings growth. MTGE is two years old, but the company's management has long experience running high-wire financial companies. The same people run American Capital Ltd. (ACAS), a business development company that survived the credit meltdown but is on the mend, and American Capital Agency Corp. (AGNC), another mortgage REIT whose name tells you that it invests only in government-backed loans.

Next is Apollo Residential Mortgage (AMTG; $22.68; 12.3%). Stewart says it's a plus that Apollo has a large amount of its portfolio in 15-year loans, which offer more protection from an interest-rate spiral than longer-term mortgages. (When interest rates rise, the value of existing debt falls. The longer the duration of a fixed-income security, the steeper the drop.). Because Apollo focuses on residential loans, the already perceptible rise in housing prices seems likely to further boost the net asset value and the shares.

AG Mortgage Investment Trust (MITT; $26.21; 12.2%) has a seasoned management team and a portfolio heavy with nonagency loans with generous yields. About 18% of MITT's portfolio is in nonagency securities. That, says Stewart, is higher than most mortgage REITs. Despite the generous yield, MITT has cash to spare thanks to earning enormous capital gains on the sale of securities within the portfolio in 2012. It is the only public fund managed by Angelo, Gordon & Co., a hedge fund sponsor that is involved in all kinds of distressed debt and turnarounds — including major metropolitan newspapers (some of which own valuable real estate).

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Invesco Mortgage Capital (IVR; $20.57; 12.6%), sponsored by the Invesco mutual fund group, owns residential and commercial loans, with a much higher share of nonagency assets — 50% in total — than most other mortgage REITs, including the others listed here. The REIT also has $300 million on hand from a secondary stock offering, which, once invested, ought to boost earnings substantially but isn't yet priced into the stock, says Ross. This appears to be among the highest-risk and highest-potential-reward mortgage REITs.

Finally, there's Western Asset Mortgage Capital (WMC; $22.27; 16.2%), run by Western Asset Management, the able fixed-income subsidiary of Legg Mason. Ross, who isn't exactly unbiased because her investment firm helped take WMC public less than a year ago, says this REIT is well positioned to support a higher yield than the category average and yet sustain its market price. Then again, that's a guess because this REIT is so new and its portfolio of almost entirely 30-year agency mortgages will surely be fleshed out into other areas with more credit risk but possibly less interest-rate risk. WMC's stock price is up a respectable 19% since going public last May, a good sign, and that super yield — well-covered by cash flow — might overcome any short-run missteps.

If you would like to speculate on this category but are uncomfortable betting on individual stocks, you can choose between two exchange-traded funds that specialize in mortgage REITs. The older one is iShares Mortgage REIT Capped ETF (REM). It sports a current yield of 11.7% and, according to Morningstar, generated a total return over the past year through March 7 of 24.7%. The fund earned 4.4% annualized over the past five years, hurt mainly by a 42.9% loss in 2008. Annual expenses are 0.48%.

The other entrant is Market Vectors Mortgage REIT Income ETF (MORT), which launched in 2011. It yields 10.7% and returned 26.0% over the past year. Annual expenses are currently a whopping 1.19%, but the fund is capping fees at an annual rate of 0.40% until September 1. If you plan on investing for a while, watch to see what the ETF has to say about fees as that date approaches.